Challenges and opportunities: How hedge funds are grappling with ESG, remote working and the ‘portfolio conundrum’

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With traditional equity and credit returns set for a squeeze, and ESG, Covid-19 and remote working upending the hedge fund industry from both an investment and operations perspective, managers face both considerable challenges and sizable opportunities up ahead, speakers at EisnerAmper’s 6th annual Alternative Investment Summit said this week.

Opening this year’s event, the ‘Future of Hedge Funds’ panel explored an assortment of industry themes and trends – including the increased importance of ESG considerations, the far-reaching operational changes stemming from the Covid-19 pandemic, and the range of emerging investment opportunities coming down the pipeline.

Simon Fludgate, head of operational due diligence of Aksia, described a “cataclysmic shift” in how much investors care about ESG, but observed how different people want different things from ESG policies, acknowledging a contrast between sentiments in US and Europe. He pointed to “two fundamental pillars” – the diversity of a firm’s staff and management team, and the carbon footprint of a firm and its investments – as key areas of focus in ESG considerations right now.

Paul Glazer, CEO at Glazer Capital, said that in the past two years a majority of potential investors doing due diligence on his firm now probe its ESG policies.

However, ESG remains “very much in the eye of the beholder,” according to Alan Reid, founder and managing partner, at rPartners, who noted that “one of the challenges is that very few people share the same similar values on all fronts.”

Scott Radke, CEO of New Holland Capital, pinpointed how hedge fund firms are implementing ESG and sustainability factor in two main ways. The defensive approach centres around risk identification, with fundamental credit and equity managers zeroing in on the earnings or balance sheet implications of an environmental or social event. The offensive implementation, meanwhile, sees managers building portfolios specifically designed to have an impact orientation.

The session also examined some of the major emerging industry trends, with Radke highlighting the growing interest in private investment by hedge funds who had historically focused on public equities.

“Obviously this isn’t brand new - we saw hedge funds dip their toe in a reasonably big way into illiquid assets prior to 2008 and then saw a big pullback from that. So I think to some extent there’s some cyclicality to this,” he told the panel.

Glazer meanwhile explained how his firm – which focuses on merger arbitrage opportunities – has been investing in SPACs since 2009, with this corner of the market becoming “a hot area” towards the end of 2019 into 2020.

“I think due to Covid people were at home, they were bored and they just started buying SPACs anytime they announced a deal,” Glazer said of the SPACs surge. “It was good for us – we were up 37 per cent in 2020 which is far beyond anything we ever had before.”

While last year’s SPACs frenzy “seems to be over right now,” the sector has become legitimate, with some 400 SPACs outstanding, he added. “That’s a permanent change and that's going to be with us going forward as a place to invest.”

“Families continue to be very focused on fees and they hate paying fees,” Reid said of the family office perspective. “People care about fees and they want to feel like they’re getting something for their fees. So typically families are much more interested in co-investment opportunities, opportunities where they feel like they can add some value.”

Expanding on this point, Reid pointed to a number of families, particularly among first generation entrepreneurs on the west coast, that are working together to make direct investments themselves. “They believe that they bring the alpha themselves and that Wall Street doesn't have any alpha to offer.”

The panel discussion also touched on the evolving nature of hedge funds’ operations, reflecting on how the Covid-19 pandemic has shaken up the working environment, and weighing up what changes may be here to stay.

Glazer spoke of the effectiveness of conducting due diligence via virtual conferencing, while Fludgate noted that although many firms are gradually returning to the office, many are likely to remain in a hybrid model. Both however acknowledged the challenges of building a team culture in the remote working environment.

Reid meanwhile underlined the importance of in-person meetings, describing a recent family office-focused event he had held in the Hamptons, which was attended by more than 150 people in August during the hurricane season.

“Hurricane or no hurricane, these families showed up because they want to be there in person,” he added. “People understand the value of in-person meetings, and so while I think that there will be far more opportunities to serve clients remotely, and by Zoom, there also will be a lack of patience for folks that aren’t willing to show up in person for meaningful relationships.”

Looking ahead, Radke said one of the biggest pressures facing allocators is the view that traditional equity and credit returns are set to be lower than they have been over the last decade.

“The challenge for the hedge fund absolute return community is to identify what role we can play in trying to help solve the portfolio conundrum that this conclusion creates,” he says. “In a way it could be the biggest opportunity since, going back two decades, you saw institutional capital begin to flow in to hedge funds.

“There’s an opportunity for hedge funds to play a much more meaningful role going forward in terms of helping allocators – be it pension funds, sovereign wealth, family offices –achieve their return goals in the future in a more sustainable, robust way than just a more concentrated allocation to equity risk.”

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Hugh Leask
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